IS RECOVERY AROUND THE CORNER, OR IS THIS THE NEW NORMAL FOR THE U.S. NATURAL GAS INDUSTRY? These are difficult and uncertain times in the U.S. natural gas exploration and production sector, as prices have fallen to levels not seen in decades. Even as prices remain below levels that many consider too low to sustain development, U.S. gas production remains strong and only recently began to show signs of slowing. Although slow to react, E&P companies finally announced large reductions in capital budgets for 2016. There is widespread speculation as to if and when prices will recover to sustainable levels. While many companies have already declared or are observed to be on the brink of bankruptcy, their assets or debt could represent attractive opportunities for other investors. One person’s misfortune can be another person’s opportunity. Is the current turmoil really the opportunity of a lifetime, as it has been described by some industry observers? Will the industry recover, or will it keep producing itself into unprofitability? Many industry experts agree that current prices are too low to be sustainable. Indeed, analysis of drilling economics indicates that the large majority of wells drilled are not economic at current prices. Most wells require much higher prices in order to be profitable because their production volumes are too low to justify their full drilling and completion costs. That is why not many people are drilling, leaving rig counts at historic lows. Figure 1 illustrates the difficult economics that producers face. The chart shows the initial production (IP) rates for wells drilled in the Pennsylvania portion of Marcellus during 2015. While a small fraction of wells have high IP rates (e.g., > 10,000 Mcf/d), most have IP rates far lower than this— the distribution of wellhead productivity is skewed toward the low end. This is typical across all basins and resource types.
FIGURE 1: HISTOGRAM OF INITIAL PRODUCTION RATES FOR WELLS DRILLING IN MARCELLUS (PA) IN 2015
FIGURE 2: IMPLIED CUMULATIVE DISTRIBUTION OF BREAK-EVEN PRICES
From IP rates, we can estimate the total estimated ultimate recoverable (EUR) volumes using projected type curves and then compute the implied break-even price for a particular region. Figure 2 shows that, for the Marcellus wells in 2015. Highly productive wells have very low break-even prices, but most wells have fairly high break-even prices. By our estimate, only about 30 percent of the Pennsylvania Marcellus wells drilled in 2015 have break-even wellhead prices below $2.50/MMBtu, assuming a 12 percent internal rate of return. Meanwhile, less than 5 percent of wells are profitable at current prices ($2.00/ MMBtu). However, there is quite a bit of diversity across the state, and some areas are significantly better or significantly lower than average. Further, simply examining the number of wells is a bit misleading because higher producing wells, of course, generate the greatest volumes.The distribution of wells is skewed toward low productivity, but the economics is skewed toward highly productive wells because they drive the bottom line. In fact, most drilling programs have been paid for by a few prolific wells. If we compute the volume weighted break-even price, the economics don’t look quite as bad, but the average break-even price average across all volumes produced is still over $3.50/MMBtu. The implication is that current prices don’t reflect the production cost of the marginal source, as it would according to textbook economics. Instead, prices are far lower than marginal cost because productive capacity of the wells already producing exceeds the demand for gas. In addition, the current productive capacity does not reflect drilled but uncompleted wells waiting for demand growth and/or price increases to make them economic. It also doesn’t include drilled but not yet connected wells unable to enter the market because of infrastructure
constraints. These potential near-term supplies will add more downward pressure on prices when they show up in the market. Low prices are difficult for all oil and gas companies, but they are particularly damaging to smaller companies. Because the distribution of wellhead productivity is highly skewed toward less-productive wells, many wells need to be drilled to be fairly confident that at least a few will be highly productive and sustain ongoing operations. Drilling can be a lottery with a low probability of a high payoff. Shale is certainly a far cry from the old wildcatter days, since oil and natural gas companies now know where the resource is and how to produce it, but getting to the richest parts of the shale is still an art, and it can take a lot of wells and financial depth. In fact, 67 U.S. oil and natural gas companies filed for bankruptcy in 2015, and a study estimated that about a third of the world’s publicly traded oil and gas companies are at high risk of going bankrupt in 2016. Meanwhile, unlike the ExxonMobils and Shells of the world, smaller producers tend to be highly leveraged, many utilizing high-yield outside debt financing to fund their drilling programs. A few years ago, a lot of cheap capital was flooding into the sector, as investors wanted to participate in the shale bonanza. As drilling productivity increased and drove down the unit cost of producing shale gas and shale oil, potential margins looked good at expected future prices. However, the industry ultimately became a victim of its own success, and sharp increases in production subsequently led to a price collapse—in oil, it was partly OPEC holding production up, but in gas it was just massive oversupply within the United States. When we look back a few years (e.g., 2013), prices had already fallen from the highs seen in 2008, but many companies were expecting a moderate recovery. Those expectations evaporated as production continued to rise in spite of falling prices. An already ugly situation was capped off by a really mild 2015–2016 winter.
Egan, Matt, “U.S. oil bankruptcies spike 379%,” CNN Money (February 11, 2016), available at: http://money.cnn.com/2016/02/11/investing/oilprices-bankruptcies-spike/
Zillman, Claire, “One-Third of oil Companies Could Go Bankrupt This Year,” Fortune (February 16, 2016), available at: http://fortune com/2016/02/16/oil-companies-bankrupt/
Figure 3 compares natural gas price expectations, as indicated by Nymex futures prices (as of January 2, 2013), to actual prices. As actual prices have fallen steadily since early 2014, we see a large gap between contemporaneous expectations and what actually happened. For a long time, the effect was hidden, as oil prices were expected to be $80 to $100/bbl, causing a massive increase in oil and wet gas production, and bringing a large volume of associated gas as a byproduct. But that too stopped with the oil crash. Very simply, investments made based on much higher price expectations are now at risk.
years before production actually comes on line. Acquisitions of leases sometimes occur a full decade before marketable production occurs. Capital budgets are often set several years before wells are drilled and production occurs to monetize the investment. So, given the long lead time to investment and the speed the market showed in changing, massive investments assuming much different market conditions have made life miserable for the sector and those who have invested in it.
FIGURE 3: DIVERGENCE BETWEEN PRICE EXPECTATION IN JANUARY 2013 AND ACTUAL PRICES
Most agree that industry will recover, but when? As Figure 4 shows, current or spot prices are set by fairly inelastic supply and demand, neither of which can quickly adjust to prices. Therefore, markets can be misaligned for a significant period with long-term market fundamentals based on much more elastic supply and demand. Prices are bound to go up, but what constitutes a sustainable long-term price is far from clear. The industry will eventually rebalance to remove excess productive capacity as gas consumers and gas producers make decisions consistent with prices. However, there is a great deal of uncertainty as to how long it will take and what the recovery will look like. Basically, the question can be boiled down to “how do you get from here to there?” When will the recovery come, if at all, and what will the “new normal” look like?
The oil and gas industry has always been prone to wild swings in commodity prices because supplies cannot quickly adjust to prices. For a long time, there was an expectation that because shale wells decline pretty steeply over time, at least theoretically a soft market could be responded to much more quickly than before by simply slowing down drilling programs. But the huge increases in productivity that caused more gas to come from the big wells and just keep on coming undermined the ability of the industry to respond to the market; improvements in technologies and processes have permanently changed the game. In terms of ramping up, E&P decisions are often made
WHERE DO WE GO FROM HERE?
FIGURE 4: TRANSITION FROM AN INELASTIC SPOT MARKET TO A LONG-TERM SUSTAINABLE MARKET
HOW DO YOU GET FROM HERE TO THERE?
OPPORTUNITY FOR A NEW STUDY The questions that must be answered to address those big unknowns include: •
What has to happen to the supply-demand balance for prices to support a resumption of a lot of drilling?
What is the impact of continuing technological change that reduces break-even prices and improves performance?
How quickly can the industry recover from the current doldrums to healthy development?
How do the financial condition of producers and the financing options available to producers affect the rate of recovery in development?
To help companies and investors answer these questions and better understand and prepare for natural gas market transitions, Berkeley Research Group will initiate a multi-client gas market study. Details of the study can be found at http://www.thinkbrg.com/f-brg-natural-gas-market-study.html, or contact Tom Choi at [email protected]